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Should You “Fix” Variable Rate Debt?

September 27, 2015 — Sam H. Fawaz

While investors are keeping a close watch on the Federal Reserve for indications of when it will start raising interest rates, the consensus among economists is that it will begin its credit-tightening cycle at some point this year.

Of course there are two sides to the interest rate coin: the investor and the borrower. Rising rates are generally good news for savers and investors, but they represent an expense for borrowers and increase the cost of taking out loans and mortgages.

In the current environment, individuals may be evaluating the potential benefits of converting variable-rate loans, including adjustable rate mortgages (ARMs), home equity lines of credit, and student loans, to a fixed rate.

Only One Way to Go

Interest rates are still at historic lows and are only likely to go up from here. Personal finance experts typically favor refinancing, when practical, to a fixed rate for the stability it provides the borrower. With a fixed-rate loan the borrower will not have to be concerned if there is a sudden spike in interest rates. What’s more, individuals with fixed-rate debt have much more control over their budget and can plan ahead with more confidence, as they have a clear, predictable picture of their monthly income and expenses.

While adjustable-rate loans may have lower initial interest rates than fixed-rate loans, the lower interest rate is only for a set period of time. At the end of the fixed period, the monthly loan amount “adjusts” based on the market rate or index. In this case, refinancing may be a smart choice if your ARM is adjusting to an interest rate that is higher than the current market rate.

How Low Are Rates?

Just how low are short-term rates now, historically speaking? Most lenders base their variable rates off a LIBOR rate, which stands for London Interbank Offered Rate and works as a benchmark rate for banks internationally.1 As the LIBOR changes, so does the variable rate. The LIBOR is low today, compared to its 10-year and 20-year averages (see table below), but once it begins to increase, borrowers holding adjustable rate loans will see an increase in their regular payments. While most variable rate loans will have an upper interest rate cap, it is important to know what that maximum rate is — and whether you could handle that potential debt load — before signing any documents.

LIBOR — Then and Now

10-year average

20-year average

July 6, 2015

6-month LIBOR

1.95%

3.09%

0.44%

12-month LIBOR

2.17%

3.29%

0.76%

Source: Federal Reserve Economic Data (FRED). For the dates indicated. The 10-year and 20-year averages are for the period ended July 6, 2015.

Generally, a variable rate loan is a safe bet for individuals who plan to repay their loan quickly, or have a short time horizon for underlying property ownership. For example, if you plan to move within 3-5 years, refinancing to a fixed rate mortgage may not be worthwhile, when you take into account the cost of refinancing compared with your monthly potential payment (interest) savings. In general, you should be able to recoup your refinancing costs within two years to make it worthwhile in the short term.

While the Federal Reserve is expected to begin raising rates soon, it is likely to take a very measured, slow path, so there’s really no need to rush into a refinancing.

If you would like to review your current loans or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Source:

1 U.S. News.com, “Fixed or Variable: Which Interest Rate Should You Choose?” July 14, 2015